Govt seeks steep cut in devolution to states from existing 42% of tax pool

The central government, in its memorandum to the Fifteenth Finance Commission (15th FC), has sought a substantial decrease in devolution to states from the existing 42 per cent of the divisible tax pool. The Commission, on its part, has written to the finance ministry, asking for a revised memorandum in the light of the prevailing economic slowdown, tax trends, and the fiscal situation.

 Sources familiar with the developments said while the Centre’s memorandum did not mention any specific percentage of reduction, the devolution to states would go down to 33-34 per cent if its ‘wish list’ was implemented. 

“There is no explicit figure of what the Centre wants. But it has some requirements which are fairly substantive,” said an official aware of the contents of the memorandum. “If one were to take all of the Centre’s wishes into account, it will lead to a considerable decrease in the states’ share of the divisible pool,” the official added. The Commission’s internal calculations show that the result of implementing all the requests of the Centre will be a reduction in the states’ share to 33-34 per cent.

A second official told Business Standard that the 15th FC had recently written to the finance ministry with regard to a revised memorandum. Officials said the government’s assessment and outlook of the economy in the memorandum, based mostly on its Budget projections, were unrealistic.

“A lot has changed since the finance ministry submitted the Centre’s memorandum. We have asked for several clarifications in view of the moderation in nominal GDP (gross domestic product) numbers and tax buoyancy,” the second official said.

While the 2019-20 Budget assumes a 12 per cent nominal GDP growth over 2018-19, the April-June nominal GDP growth came in at 8 per cent, the lowest since the third quarter of 2002-03. Real GDP growth for the quarter was 5 per cent, the lowest since 2013.

The demand and consumption slowdown is expected to have an impact on the Centre’s tax collections. Direct tax collection has seen a growth rate of mere 5 per cent so far this year, which means that collections will need to expand by at least 27 per cent in the remaining half to achieve the Budget target of 17.3 per cent growth. There are also fears of a shortfall in goods and services tax (GST) collection.

The Commission is still awaiting a response from the ministry on a revised memorandum. In case that is submitted, the existing memorandum will be considered withdrawn. For now, the memorandum asking for a substantial reduction in the share of states stands.

To illustrate the impact of such a reduction, the share of states at 42 per cent of the total divisible pool was Rs 7.6 trillion according to the revised estimates of 2018-19, Budget documents show. At 34 per cent, that could be reduced to Rs 6.15 trillion. Similarly, for 2019-20, the devolution to states is budgeted at Rs 8.1 trillion at 42 per cent. At 34 per cent, it will be around Rs 6.6 trillion.

The 42 per cent vertical devolution was recommended by the 14th FC, up from 32 per cent recommended by the previous panel. A Finance Commission’s award period runs for a period of five years, as mandated by the Constitution. The 14th FC’s period runs from 2015-16 to 2019-20. The 15th FC’s recommendations kick in from April 1, 2020 and run till March 31, 2025.

A vertical devolution is the division of the tax pool, excluding cess and surcharges, between the Centre and states, while horizontal devolution is the distribution of resources among the states. Sources said the Commission might settle for a marginal cut in the states’ share of tax devolution. In addition, capital expenditure components of the Centre’s allocation for defence and internal security could be sequestered from its overall tax revenues. The new devolution formula could thus be applied to the Centre’s tax revenues after deducting from them its capital expenditure on defence and internal security. The report is expected to be submitted to the government on November 30.

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